12 takeaways for RIAs from a Schwab report about complex cost basis rule changes

Getting with the new cost basis rules is not optional nor can addressing them be done in half-hearted fashion.

With this in mind, a how-to manual for advisors bracing for complicated cost basis rules that go into effect on Jan. 1. 2012 has just been released by The Charles Schwab Corp. in a white paper.

Advisors who wait till the last minute may feel overwhelmed as they trying to navigate these changes.

“We’ve not seen a change this big industry wide in a very long time,” says Brian Keil, director of Cost Basis and Tax Reporting for Schwab. “Making sure that we’re all prepared is very critical. I suspect it’ll impact every advisor we do business with.”

Keil points out the white paper is available to Schwab’s 6,000 advisors as well as all other advisors as one piece of the company’s communication effort. It includes webcasts and one-on-one consulting efforts with RIAs who need guidance.

For its part, competitor Boston-based Fidelity Investments issued its own white paper for advisors outlining cost-basis changes more than a year ago. See: Fidelity delivers a white paper and a warning to RIAs regarding new cost-basis rules.

1.) Takeaways

Here are the most important points from Schwab’s white paper.

Starting this Jan, 1, under the Emergency Economic Stabilization Act of 2008, custodians were required to report the adjusted cost basis of sold securities to the IRS for the first time. The new regulations, designed to capture accurate reporting of investors’ gains and losses at tax time, have created complex reporting procedures

2.) Three phases

• The first phase took effect on January 1, 2011, covering equities acquired on or after that date. These changes will be most noticeable to clients in early 2012, when they receive the new Form 1099-B reporting cost basis information for the first time. Cost basis information on any equities bought and sold in 2011 will also be reported to the IRS.

• The second phase begins on January 1, 2012, covering mutual funds, Dividend Reinvestment Plan or DRIPs and most ETFs acquired on or after that date. Brokers and custodians will be required to report this information to the IRS for the first time in 2013 on Form 1099-B, covering the 2012 tax year.

• The third and final phase takes effect on January 1, 2013, covering other specified securities, including fixed income and options. The IRS had not yet issued regulations on this phase as of the date of this writing.

3.) Synchronizing systems

One of the biggest challenges for RIAs is ensuring their portfolio management software is synchronized with the information and system used by their custodian. RIAs using multiple custodians need to ensure that the cost-basis information they have documented is passed on to clients by the custodian in with the same numbers.

RIAs need to consider tax consequences of a trade because cost-basis methods can’t be changed after a trade settles.

4.) Default methods

This year, the cost basis default method was established because the legislation requires advisors to use a default cost basis method for calculating gains and losses unless a client or advisor chooses another method. For equities, the IRS default on sold securities is the first In first out (FIFO) method.

Advisors and their clients can change the default method or override it for a specific trade. There are various other methods to specify lots, including high cost, low cost, last in first out (LIFO) and specific share identification.

5.) Going gets rougher

Schwab predicts that when clients receive the new form 1099-B in early 2012 it will be a source of questions from clients because they’ve never gotten this form from their custodian before.

“Because they may turn to you as their trusted advisor with these questions, you may experience an increase in call volume during tax season. Be prepared to guide your clients through the new form and what it means for them,” the white paper says.

For mutual funds, ETFs and DRIPs, brokers can use average cost (with shares sold in FIFO order) as their default method, or specific identification, which can include standing instructions for a cost basis method.

6.) Bifurcation

The key change starting in 2012 relates to bifurcation, which indicates a mutual fund position with two average costs: one for the uncovered shares and one for covered shares. Currently held mutual funds will not be covered by the legislation when the second phase takes effect on January 1, 2012, but additional shares of the same fund purchased after the effective date will be covered.

These share lots will have to be tracked separately for cost basis purposes.

Adding to the confusion, custodians may report cost basis for covered and uncovered shares in different ways.

7.) Average cost method

Another development with the second phase of the legislation is that RIA clients who currently use average cost for their mutual funds will be able to move out of average cost to another method by making their request in writing. IRS approval is no longer required in order to change from the average cost method. The starting basis will be averaged at the time of the change, and the average cost method will apply to shares owned at that time.

8.) Communication

In the Schwab white paper, RIAs explain how important communication efforts are to ensure their clients aren’t confused by these complex changes.

“For the next phase of the legislation, we’ll be doing proactive communications with clients again, talking about the impact of the legislation on mutual funds and promoting the new 1099-B form,” says Barb Blauw, assistant vice president for support operations at The Mutual Fund Store.

Last year, the firm included information about cost basis changes in its third- and fourth-quarter newsletters, and emailed clients at year-end to remind them of the firm’s default method. Blauw says she anticipates sending similar communications this year.

The Mutual Fund Store also held a webinar last year to educate its advisors about the details of the changes and prepare them for questions from clients, and it plans another in the third quarter of this year.

Schwab encourages advisors to reach out to their clients’ tax professionals so that they’ll be expecting the new Form 1099-B.

9.) Less paperwork

Since gain and loss information will be included on form 1099-B generated by the custodian, RIAs could consider forgoing their own process of generating these reports for clients. It may free up staffers to work on other projects.

That’s exactly what Mark Riley, operations manager and chief compliance officer of The Milestone Group, Inc. is considering doing.

“In the future, with our custodians’ data and our portfolio account data in sync, we may not have to produce these reports ourselves. It’s a fairly involved process for us to produce those reports at the end of the year.”

10.) Back office

Advisors must ensure they’re aware of their custodian or broker’s default methods and decide if they want to use those default methods for gains and losses or use their own method. If RIAs think their clients would prefer another method such as average cost, reach out to them.

11.) Data download and reconciliation

If RIAs haven’t already implemented workflow changes and reconciliation processes, they should take the time now to assess whether they need to add a step to their firm’s back-office workflow to ensure that there are no discrepancies between their cost basis information and their broker’s.

If clients report cost basis information on their tax returns that differs from what was reported on Form 1099-B, the IRS could take notice.

Lori Dierke, operations manager at Accredited Investors Inc., recommends double-checking with brokers that any cost basis information advisors have uploaded has been correctly received and recorded. “We found that immediate follow-up helped us to catch errors,” she says in the paper.

12.) Opportunities for Advisors

By helping to guide clients through the new cost basis reporting laws, advisors stand to enhance their value to their clients. For advisors who have clients with multiple advisors, this is an opportunity to demonstrate the value of working solely with them.